Tag: bubble

In recent years, it’s been the opposite of controversial to say that the tech industry is in a bubble. The terrible recent stock market performance of once high-flying startups across virtually every industry (see table below) and the turmoil in the stock market stemming from low oil prices and concerns about the economies of countries like China and Brazil have raised fears that the bubble is beginning to pop.

While history will judge when this bubble “officially” bursts, the purpose of this post is to try to make some predictions about what will happen during/after this “correction” and pull together some advice for people in / wanting to get into the tech industry. Starting with the immediate consequences, one can reasonably expect that:

Exit pipeline will dry up: When startup valuations are higher than what the company could reasonably get in the stock market, management teams (who need to keep their investors and employees happy) become less willing to go public. And, if public markets are less excited about startups, the price acquirers need to pay to convince a management team to sell goes down. The result is fewer exits and less cash back to investors and employees for the exits that do happen.

VCs become less willing to invest: VCs invest in startups on the promise that future IPOs and acquisitions will make them even more money. When the exit pipeline dries up, VCs get cold feet because the ability to get a nice exit seems to fade away. The result is that VCs become a lot more price-sensitive when it comes to investing in later stage companies (where the dried up exit pipeline hurts the most).

Later stage companies start cutting costs: Companies in an environment where they can’t sell themselves or easily raise money have no choice but to cut costs. Since the vast majority of later-stage startups run at a loss to increase growth, they will find themselves in the uncomfortable position of slowing down hiring and potentially laying employees off, cutting back on perks, and focusing a lot more on getting their financials in order.

The result of all of this will be interesting for folks used to a tech industry (and a Bay Area) flush with cash and boundlessly optimistic:

Job hopping should slow: “Easy money” to help companies figure out what works or to get an “acquihire” as a soft landing will be harder to get in a challenged financing and exit environment. The result is that the rapid job hopping endemic in the tech industry should slow as potential founders find it harder to raise money for their ideas and as it becomes harder for new startups to get the capital they need to pay top dollar.

Strong companies are here to stay: While there is broad agreement that there are too many startups with higher valuations than reasonable, what’s also become clear is there are a number of mature tech companies that are doing exceptionally well (i.e. Facebook, Amazon, Netflix, and Google) and a number of “hotshots” which have demonstrated enough growth and strong enough unit economics and market position to survive a challenged environment (i.e. Uber, Airbnb). This will let them continue to hire and invest in ways that weaker peers will be unable to match.

Tech “luxury money” will slow but not disappear: Anyone who lives in the Bay Area has a story of the ridiculousness of “tech money” (sky-high rents, gourmet toast, “its like Uber but for X”, etc). This has been fueled by cash from the startup world as well as free flowing VC money subsidizing many of these new services . However, in a world where companies need to cut costs, where exits are harder to come by, and where VCs are less willing to subsidize random on-demand services, a lot of this will diminish. That some of these services are fundamentally better than what came before (i.e. Uber) and that stronger companies will continue to pay top dollar for top talent will prevent all of this from collapsing (and lets not forget San Francisco’s irrational housing supply policies). As a result, people expecting a reversal of gentrification and the excesses of tech wealth will likely be disappointed, but its reasonable to expect a dramatic rationalization of the price and quantity of many “luxuries” that Bay Area inhabitants have become accustomed to soon.

So, what to do if you’re in / trying to get in to / wanting to invest in the tech industry?

Understand the business before you get in: Its a shame that market sentiment drives fundraising and exits, because good financial performance is generally a pretty good indicator of the long-term prospects of a business. In an environment where its harder to exit and raise cash, its absolutely critical to make sure there is a solid business footing so the company can keep going or raise money / exit on good terms.

Be concerned about companies which have a lot of startup exposure: Even if a company has solid financial performance, if much of that comes from selling to startups (especially services around accounting, recruiting, or sales), then they’re dependent on VCs opening up their own wallets to make money.

Have a much higher bar for large, later-stage companies: The companies that will feel the most “pain” the earliest will be those with with high valuations and high costs. Raising money at unicorn valuations can make a sexy press release but it doesn’t amount to anything if you can’t exit or raise money at an even higher valuation.

Rationalize exposure to “luxury”: Don’t expect that “Uber but for X” service that you love to stick around (at least not at current prices)…

Early stage companies can still be attractive: Companies that are several years from an exit & raising large amounts of cash will be insulated in the near-term from the pain in the later stage, especially if they are committed to staying frugal and building a disruptive business. Since they are already relatively low in valuation and since investors know they are discounting off a valuation in the future (potentially after any current market softness), the downward pressures on valuation are potentially lighter as well.

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Today, it seems perfectly obvious that building an internet business to sell pet food to customers where shipping and logistic costs (let alone advertising costs, etc.) wiped out any chance of profitability was an idea doomed to fail.

But, was it obvious at the time? While some folks will claim they knew all along, the market evidence suggests that most people had no clue: after all, the company raised over $110M in capital from Hummer Winblad, Comcast, Amazon.com, and others. It went on to successfully IPO in 2000 and at one point employed over 300 people. If it was such a terrible idea, it seems that it took quite a while for people to catch on.

This isn’t to specifically pick on Pets.com – quite the opposite: when you work in technology, there is oftentimes so much change and uncertainty around the future that its not obvious that the “emperor has no clothes” until its too late, oftentimes driven by entrepreneurs, career-seekers, and investors willing to pile on to make sure that they “get in on the action before its too late.”

And therein lies a very interesting question: what are the ideas/companies that have generated a ton of traction today which will become “duh, stupid” Pets.com ideas of tomorrow?

Examples of companies that flew high once and “obviously” crashed afterwards (most of the Dot Com bubble companies, many of the Cleantech bubble companies, some prominent consumer internet companies, etc) suggest that ignoring economic realities is a common refrain. Many of the failed Dot Com bubble companies and many of the challenged consumer internet companies relied primarily on drawing eyeballs to their websites/apps without figuring out how to make money enough on them to recoup their costs of marketing & advertising. The cleantech companies, similarly, gambled wrongly on government support and on their ability to make their technologies competitive with conventional systems.

But, the danger of generalizing from this type of thinking is that are plenty of examples of huge companies which succeeded despite bleak economic pictures in the early days. Amazon.com is a particularly noteworthy company that aimed to grow first before worrying about profitability (something it continues to do in a number of new businesses), not generating profit until late 2001, 7 years after founding, and over 4 years after it went public. Considering the company is worth over $100B today, compared with roughly $400M when it went public, it would seem blindly paying attention to the immediate economic picture would’ve cheated you out of a very impressive investment.

The truth is that I don’t have a good answer to this question. Studying what led to the failure of past startup models can be very informative in terms of how to think about other businesses, but the truth is that we aren’t likely to know until it hits us. Who knows, maybe in a few years “Big Data” or “Mobile advertising’ might all be revealed to have been terrible businesses…?

I would love to hear any thoughts on the subject in the comments below.

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One of my favorite RSS feeds is Business Insider’s Chart of the Day. This chart came up a few weeks ago and made me think. It’s quite staggering to imagine that college tuition has outpaced inflation as rapidly as it has (~10x vs. ~4x over 30 years). The graph made me think: Has the value of a college education increased 2.5x? If it has, then there isn’t necessarily a bubble. There are three ways to think about the value of a college education to evaluate this question.

The most obvious is the average income comparison between an average high school graduate (only) and an average college graduate (only). Using US government statistics, we find that in 1978, a college-educated graduate made ~55% more than an individual with only a high school education. In 2008 (the last year I have data for), a college educated graduate made ~87% more – which amounts to a 60% increase in the gap. Now there are obviously nuances in that figure (which I’ll let the policy experts correct in the comments if they choose), but this 60% figure is a decent order-of-magnitude impact (and even holds true if I adjust for the change in disposable income using the individual, under-65 poverty line as the base level of expenditure), and barely covers the 2.5x increase in tuition costs over inflation.

Related to the above are the other effects of college education on lifetime income. It’s been demonstrated that college educated individuals live longer than those who don’t, and its commonly understood that college is a prerequisite for other income-boosting opportunities like graduate school. One’s lifetime income is also much more likely to trend upwards in life with a college education than with only a high school diploma. But there’s an interesting wrinkle here: does college education make you live longer and get promoted, or is it just an indirect way of finding individuals who tend to be wealthier and more intelligent? I unfortunately don’t have the data (or the time 🙂 — this is a casual blog post after all!) to run all the calculations needed to understand the impact, but I would hazard a guess that it’s probably overly-aggressive to assume that these second-order lifetime income benefits can close the gap between tuition costs and inflation.

The last “source of value” for a college education is the subjective value of meeting lifelong friends, having new experiences, and expanding your intellectual horizons. Just because its last and extremely intangible, doesn’t mean there’s not enormous value here. But, the question to ask here is not whether or not college has large intangible value (of course it does), but whether or not you believe that intangible value to have increased significantly (by over 2.5x as we’ve concluded the increase in lifetime income likely isn’t enough to explain the 2.5x increase in tuition cost relative to inflation) since 1978. I personally think that’s being overly aggressive.

I can’t pretend to be the expert on this, but at this point, I’d conclude that whereas the value of a college education has increased dramatically (maybe even by as much as 75-100%), it hasn’t gone up enough to justify a 2.5x increase relative to inflation. If you accept my conclusion then the obvious question is what is causing tuition to increase so much? Two possible explanations jumped out at me:

Tuitions haven’t caught up with the value of a college education: While my conclusion above was that the value of a college education hasn’t increased 2.5x from 1978 until today, one possible explanation of tuition price is that the value of a college education is still higher than what students pay for it, and, if that were true, we would expect tuitions to continue to increase.

Tuitions are higher than the value of a college education and are being propped up by a combination of two things:

Tuitions are being boosted by a subsidy cycle: Free money from the government is one of the easiest ways to get price increases. While we often think of the US government’s subsidized loans and tax writeoffs for college tuition as a means to help more people attend college, an equivalent way of thinking about it is that it gives colleges free rein to increase prices without worrying about reducing the number of people who enter. In a “normal” market, this would be the end of it (slightly higher prices, but more people entering college), but because college education has become such a political affair (every family always thinks its “too expensive”, and every politician promises to make it cheaper), we always get more subsidies from more politicians which feeds back into the original problem.

Families have bad expectations around the value of a college education: One explanation, which is making the rounds of the policy wonk blogosphere, is that this is all a big bubble. In the same way that people felt tech stocks in the late 90s and real estate in the 2000s were a good buy, its entirely possible that families have uninformed expectations about the value of a college education and thus believe the higher tuitions are worth it. If this is true, then we could be on a collision course with a generation of families (like in the 80s) suddenly realizing “the emperor (of college tuition) has no clothes!” (which might be precipitated by a long stagnation/decline in the wages of college educated individuals) followed by a potential crash in tuitions.

What should be done? Truthfully, it depends on which of these conclusions is correct. If its just that tuitions haven’t caught up with the value of a college education, then it makes sense that tuitions are increasing, and it may even make sense to increase tuition grants/subsidized loans (as it likely means not enough people are getting a college education because they couldn’t get access to the capital to pay for it). However, if tuitions are over-valued, then it would be advisable to end the college tuition subsidy cycle and implement policies which potentially “soften the blow” of the coming college education value and tuition crash.

But to make the right policy decisions and tradeoffs, its important to first understand which of the two explanations is correct. And that’s a whole ‘nother set of data and analyses…